TY - JOUR
AU - Jagannathan,Ravi
AU - Meier,Iwan
AU - Tarhan,Vefa
TI - The Cross-Section of Hurdle Rates for Capital Budgeting: An Empirical Analysis of Survey Data
JF - National Bureau of Economic Research Working Paper Series
VL - No. 16770
PY - 2011
Y2 - February 2011
DO - 10.3386/w16770
UR - http://www.nber.org/papers/w16770
L1 - http://www.nber.org/papers/w16770.pdf
N1 - Author contact info:
Ravi Jagannathan
Kellogg Graduate School of Management
Northwestern University
2001 Sheridan Road
Leverone/Anderson Complex
Evanston, IL 60208-2001
Tel: 847/491-8338
Fax: 847/491-5719
E-Mail: rjaganna@northwestern.edu
Iwan Meier
HEC Montreal
3000, chemin de la Cote-Sainte-Catherine
Montreal (Quebec) H3T 2A7
Canada
E-Mail: iwan.meier@hec.ca
Vefa Tarhan
Loyola University Chicago
Graduate School of Business
1 E. Pearson St., Maguire Hall
Chicago, IL 60611
E-Mail: v-tarhan@luc.edu
AB - Whereas Poterba and Summers (1995) find that firms use hurdle rates that are unrelated to their CAPM betas, Graham and Harvey (2001) find that 74% of their survey firms use the CAPM for capital budgeting. We provide an explanation for these two apparently contradictory conclusions. We find that firms behave as though they add a hurdle premium to their CAPM based cost of capital. Following McDonald and Siegel (1986), we argue that the hurdle premium depends on the value of the option to defer investments. While CAPM explains only 10% of the cross-sectional variation in hurdle rates across firms, variables that proxy for the benefits from the option to wait for potentially better investment opportunities explain 35%. Estimates of our hurdle premium model parameters imply an equity premium of 3.8% per year, a figure that is essentially the same as that reported in the survey by Graham and Harvey (2005). Consistent with our model, growth firms use a higher hurdle rate when compared to value firms, even though they have a lower cost of capital.
ER -